Monday, April 07, 2014

The foxy Fed

A few days ago, the Fed released its workhorse model of the macroeconomy - the FRB/US model - to the public. The model had been only semi-private before, since the Fed would send it to interested researchers, and revealed some information about it to the general public. But now the model is fully public. How should we interpret that action?

Why didn't the Fed fully reveal FRB/US model before now? It always seemed to me that it was basically because of - for lack of a better word - embarrassment. Academic macroeconomists haven't used or studied this type of model in decades (having abandoned everything else in favor of DSGE). In 2010, Chris Sims appeared to call models like FRB/US "something close to a spreadsheet". Since most Fed employees are drawn from the same pool of people as academic macro (and interact with academic macroeconomists quite frequently), the fact that they use something like FRB/US must have seemed a bit awkward. In fact, I've heard academic macroeconomists make fun of FRB/US a number of times.

So if my guess is right, the Fed's publication of FRB/US indicates that whatever embarrassment existed is now essentially gone. That is kind of interesting.

After all, FRB/US flies in the face of two key developments in academic macro. Since FRB/US has a huge number of parameters, all of which are assumed to be structural, it is a lot harder for this model to pass the intuitive test known as the "Lucas Critique". Basically, more "structural" parameters = more assumptions = more chance to get some of the assumptions wrong = easier for any given economist to wrinkle his nose at the model.

Second, FRB/US does not force its users to use Rational Expectations (which the Fed more aptly calls "Model Consistent Expectations" or "MCE"). The model has an option that allows you to use it with MCE. But it also has an option to allow you to use it with non-model-consistent expectations. That flies in the face of what Robert Lucas told economists to do, and what most academic macroeconomists do in fact do.

Lucas and his followers (and "his followers" include almost 100% of academic macroeconomists working after 1980, to a greater or lesser degree) hoped and expected that DSGE models, which have a relatively small number of parameters and generally only consider the MCE case, would fully replace models like FRB/US at central banks. But that has not happened, despite decades of arguments by academics. The Fed and other central banks do indeed use DSGE models, but they continue to use things like FRB/US as well. Where academic macro is hedgehoggy, central banks are stubbornly foxy.

And I say "stubbornly" because instead of becoming more and more shy about their continued deviation from academia, the Fed now seems to be getting more bold about it. In their notes on the public release of FRB/US, they very explicitly show how the model is used not just for unconditional forecasting, but for policy analysis - exactly the thing that Robert Lucas told us that we shouldn't do with this kind of model.

That's my (non-insider) takeaway from the public release of FRB/US - the Fed seems less embarrassed about its continued split with academic macro.

(Note: I'm definitely not calling the Fed cowards for not releasing FRB/US before now; in fact, the opposite. It takes lots of guts to keep using a diverse array of models when some of the world's smartest hedgehogs are yelling at you to use only one kind! Instead, I think it's the academics who might want to pause and think about why even central banks, their main audience, aren't totally sold on their approach even after more than three decades...)

Update: Steve Williamson has more. He's not a fan of FRB/US, but he agrees with me that the main takeaway from its continued existence is that the Fed has not fully bought into the ideas of Robert Lucas.

I usually disagree with John Taylor but he has interesting blog posts.

http://economicsone.com/2014/04/05/transparency-for-policy-wonks/

"In his review in the Wall Street Journal blog, Jon Hilsenrath criticizes the Fed’s model because “it missed a housing bubble and financial crisis,” but I don’t think that was simply the model’s fault. Rather it was due to policy mistakes that the model, if used properly, might have avoided. And models which included a financial sector or financial constraints do not do any better. We will see how the new models being built now do in the next crisis."

I agree we'll have another crisis but not for a while seeing as how many financial institutions vanished during the last one.

It is my understanding from my various interactions with people at various Feds and other central banks is that most of them have (at least) three models, one like this one just released, which is apparently an update with lots of bells and whistles from someting like the old Wharton model, which in turn is essentially a complicated fancy version of an ISLM model, with a lot of chagnes (some of them involving supply side stuff, if not ratex new classical stuff).

Another is some sort of VAR Sims type model, but a much fancier version than his original.

The other is some sort of DSGE model. They have it. They just do not believe it enough to actually use it for policy analysis, although at some places they kind of look at all three models and sort of average or play Delphi meta games.

Very few of the central banks have solid ABMs, which I find disappointing, although there is some fiddling with them going on in some places, as well as with some network models, with Haldane at the Bank of England an especial fan of the latter.

Even the most complex models are fairly small due to limited resources. The best out there would be the latest update to EURACE which is still only 1600 households, 80 firms, 2 banks, 1 CB, and 1 govt (consistent tax). See http://ssrn.com/abstract=2408969

It at least has outputs that are stock/flow consistent, has credit and stock markets, persistent heterogeneity, and outputs show fat tails and Laplace distributions. Decision making and learning are micro-founded on behavioral science and modern management science. The only limiting factor in a model like this is flops.

I don't think Fed should just include the EURACE model, but they might set up a model along these lines and try to develop it further with their own policy interests in mind. ABMs in general need a lot of development and experimentation; they are, after all, in their infancy for applications in economics (unlike, say, traffic or epidemiology or growth of bacterial colonies or even financial markets). Another very interesting model has been developed in the European CRISIS project, which has involved several US researcher as well. See http://arxiv.org/pdf/1307.5319.pdf for a discussion of endogenous phase transitions or tipping points in this model, where an economy can go abruptly between states of low or high unemployment.

I'm not involved in any of this work directly, but I'm sure some of the people I know who are would be interested in making contact with FRB staffers and looking at possible collaborations. They might well have connections already, but if you could help make others, I'd be very surprised if they weren't interested. I'd certainly be happy to contact some of the key people I know and put them in touch with you or anyone you suggest.

Agent based models should be a great tool for short term forecasting. To me it seems like it would b beneficial if they could approach forecasting like weather forecasting. Short-term forecasting that is highly accurate out to a limited time, longer term forecasts that are much more generalized, and very long term forecasts that tackle big questions like climate change. Is the economy really all that different? The more I look at the metaphor the more apt it seems. Forecasters have to take shocks like volcanoes into account, there are long term cycles like el nino that temporarily dumb massive amounts of heat into the atmosphere that completely changes the equilibrium. It just seems to work as an analogy.

Mark, There are some collaborations going on with some of the folks from Cars Hommes's shop in Amsterdam working with people at ECB. However, it is rather curious that many central bank decisionmakers have openly called for more work on ABMs with not all that much of it going on. Despite the Board of Govs releasing their non-DSGE model, the majority of research in the backrooms continues to be dominated massively by DSGE approaches.

The Bank of Canada has been using a large-scale DSGE for several years now as its main forecasting and policy analysis tool. From the sounds of it, the new Governor of the BoC is less than impressed with the results: http://www.theglobeandmail.com/report-on-business/bank-of-canada-adapting-economic-models-to-new-reality/article17721912/#dashboard/follows/

assume fed has accurate model. the existence of the model affects what fed does which affects economy. this invalidates the model as no model can contain itself. therefore the fed can never have an accurate model (unless they do nothing with it)

Yes, I also thought that public knowledge of a model would impact the effects of that model. Either there really is less embarassment about their model now, or they are confident that they can foresee the reactions to their model.

Worrying about whether the model is well-founded in theory, especially economic theory, is nonsense. These people have to make decisions which have major impacts on many people's lives. As much as possible they have to get their analysis and forecasts right. It's odd that academic economists can even have a problem with this. It demonstrates how much the profession is in thrall to DSGE and micro-economic theory that has been drummed in to them through college that such a discussion can even take place.

I wonder when it comes down to the wire, whether any of these models are really seriously considered by the authorities when it ultimately comes to calling the decisions. I think the math goes, the figures come in, and there is a lot of subjective weighing of scenarios and options. I also get the impression that many central bank governors are more guided by historical case studies than theory.

Interestingly, I was looking through some of the programs, and there is a note in the changelog at the top of one, "Fixed code for constrained TC policy in R -- still need to do matlab". (The program is mce_solve_library.prg.)

It seems like a bad idea to have multiple versions of a standard model, but like you, I wish it came in an R flavor. (Matlab would be okay, I guess. Better.) As it is, can kinda sorta read it, but can't run it.

"In their notes on the public release of FRB/US, they very explicitly show how the model is used not just for unconditional forecasting, but for policy analysis - exactly the thing that Robert Lucas told us that we shouldn't do with this kind of model."

I'm not sure this is quite right. In the original 1976 Critique article, Lucas warned about failing to distinguish between 'parameters' that were amenable to policy--in short, expectations--and those that were immutable to policy--'structural' parameters. FRB/US when simulated with model consistent expectations is consistent with the Lucas critique in this sense. One can go further, of course. In his 1987 monograph "Models of Business Cycles," Lucas joined hands with Kydland and Prescott to argue that the immutable parameters should also be structural in the sense of being describable in terms of taste and technology. That's a separate question. In any case, what is 'structural' tends to be a matter of taste. The FRB/US model, for example, uses the idea of polynomial adjustment costs (PAC) to pin down intrinsic (that is, immutable to policy) model dynamics; these are just a generalization of quadratic adjustment costs a la Rotemberg (1982). When the model group at the Board first took FRB/US on the road to top economics departments back in 1997, they hated that, but in the end, Christiano, Eichenbaum and Evans (2005) used PAC, if by another name, to model capital stock adjustment dynamics. More generally, the definition of what constitutes an acceptable microfoundation has turned out to be fairly elastic.

Typically, the Board staff use FRB/US in its model consistent expectations (MCE) mode when analyzing a policy that is a candidate for use over an extended period of time, so that agents can learn the policy, or when extended efforts at public communication are contemplated to make private agents cognizant of the policy. The Board staff use non-MCE--called VAR-based expectations--when just a small perturbation to the extant rule is under consideration, or when current economic conditions are thought to be germane to the question.

The Fed staff debated, off and on, putting FRB/US in the public domain but the staff were worried about having to provide support to a host of impromptu users. Now, you could say "no promises, no support" but if people misuse the model and put misleading or erroneous results in the public domain you could find yourself having to support the model regardless of what you claim. So the Board staff provided the model on an ad hoc basis to people who asked for it and who had the background to run it. The rest of the story is as Claudia, above, describes it.

Let me add another point beyond my support for agent-based modeling, which I have been involved with myself personally, if not on a scale for use to forecast for central banks.

This other matter is that most of regional Fed bank presidents who show up for the decisionmaking FOMC meetings (and they all show up and have a voice, even if they are not voting) rely partly on private communications that they have with local business people in their regions. The longer they are in office the more important these sorts of private communications become as they cultivate the leading CEOs of their respective regional economies. Indeed, a theme rarely discussed in these matters is that FOMC meetings do not just involve debates over the value or future prospects of macro variables or differences in views about macro policies across regional Feds, but actual differences in regional economic outcomes within the US, with the regional Feds representing the economic interests of their regions, without getting into details of which Fed represent which interests. When the US economy is moving up and down together, this is not a big deal, but there are times when it does not do so, such as when exogenous oil price shocks hit, and then the regional Feds may well end up disagreeing sharply over what Fed policy should be.

The Fed has also released its EDO (DSGE) model which as they say has been used for forecasting and policy analysis since 2006.

Therefore, I don't really understand why does publishing FRB/US model in addition mean it has more weight in the policy analysis than the aforementioned DSGE model. This post essentially says just that, if I understood it correctly (i.e. that DSGE models were/are not important for central banks - academic macroeconomists main audience). I'd really appreciate if you could elaborate a bit more on that point.

Which, I think, is natural, as they have invested a lot of human capital in developing that model since 1990s and it had proven to be useful (I guess) during that time. After all, DSGE models are not perfect models of the world. There obviously are questions that can be addressed better with non-DSGE models. Yet, that alone does not indicate failure of academic macroeconomists who try to "sell their approach".

However, if there are academic people who call for abandoning everything else in favor of DSGE, then, I agree, they're clearly wrong and should pause and rethink that.

I don't know that there's that much of a split as you say. Policy makers need to be more eclectic given their focus on real time economic analysis. An academic needs to specialise and be an expert, but that's ok because his/her job is more about developing one of several models or pieces of analysis that could be useful to policy makers (or business economists if they were more in touch with academic research). The policy maker/business economist' job is to create more of a synthesis applied to current events. Academics can therefore afford to be more insistent on microfoundations in their work because that makes different mechanisms more explicit and easy to identify and study. Policy makers can combine microfounded work from DSGE models with partial equilibrium work on things like precautionnary saving or credit constraints on firm decisions (partial equilibrium allows for better household or firm level microfoundations) or on different behavioural biases and it's their task to try to marry those things in their head. FRB/US may help some fed economists with that (although the fed is one of the few main central banks insisting that their projections are more judgement based and less model driven). Or you can build various forms of hybrid DSGE/VARMA models that mix DSGE equations but add some extra terms to account for information missing from the DSGE model. Or you can add missing channels as part of the shock processes in the DSGE model by allowing them to be correlated and load on other variables (think of them as a factor model that that feeds into the DSGE model). By the way these are all things that have been done, at least at the bank of England.

Good. Now, "practically 100 percent" of serious macroeconomsts will have to address this "primitive" model. Coming from that generation, many such, Klein's, Fair's, et alia. 'Adopting' Fair's model once seemed appropriate to me, as does now the FRB/US version. The problem was, each one of those many 'structural' equations was in some way not so realistic in emulating historical behavior in particular episodes. Detailed studies are required, and probably constant reparameterization. Papers on the Fair model were of little interest. Audience now, for work outside the Fed, that probes and improves the Official model, would seem universal. This release may have been the best thing the Fed could have done to improve our paralyzed intellectual continuum.

I've been watching "Cosmos." Metaphorically you seem to suggest we only need examine the exact orbits of the planets around the sun, rather than probing gravity in depth, as has occurred, bringing closer understanding.